Inflation, Central Banks, and Business Cycles

[Adapted from a lecture presented at the Mises Institute's Sound Money Conference, April 10, 2014.]

The word "inflation" means different things to different people. One popular conception of inflation focuses on prices — all prices, actually. For these people, including some economists, "inflation" means a rise in the general price level, i.e., the goods and services we buy have higher price tags.

The other conception of inflation focuses on the money supply. Economists with this focus think of inflation as an increase in the amount of money in the economy. We'll see that viewing inflation as a rise in prices can be misleading and ambiguous especially compared to viewing inflation as an increase in the money supply.

Prices Can Rise for Many Reasons

If the demand for something increases relative to its supply, or if the supply of something decreases relative to the demand for it, the price will increase.

The fundamental reason for this is called diminishing marginal utility — increasing our stock of some good means that it will go toward the satisfaction of a lower-ranked end. If the next "marginal unit" goes toward a lower-ranked end, then the most we are willing to pay for the next unit must be less than the previous unit. You might be willing to pay $600 for one Apple Watch, but the most you would be willing to pay for another might be $100, maybe as a gift for somebody else or so that you could have one on both of your wrists!

Even though this sounds pretty limiting in terms of the reasons prices can rise, these two concepts — supply and demand — can and do channel all sorts of changes in the market.

Preferences can change, goods can go in and out of fashion, accidents can happen that reduce our supply of a certain good, we can think of new and more efficient ways of producing goods, services that at one time could only be done with human labor can be replaced or complemented with new tools and machines, and so on.

The list of things that affect supply and demand is infinite, depending on how specific you get, but the important thing to remember is that all of these sorts of changes are integrated into and channeled through our preferences and ideas, and therefore supply and demand.

There Is No Good Way to Measure a General Rise in the Price Level

You maybe familiar with indexes like the Consumer Price Index, which are calculated and compiled based on survey data and technical mathematical methods, but by their very nature they cannot appropriately capture the price level. They cannot do so because these sorts of indexes are one number.

They try to boil the trillions of pieces of data on the prices of all goods and services in the economy down to just one piece of data. Market prices, which are a complicated phenomenon on their own, fluctuate not only year to year, but month to month, day by day, and even second to second. Also, there is no central repository of price information.

Even in one country, prices emerge in a very scattered, decentralized way, from the halls of Washington, D.C. to the dark, back alleys of downtown Chicago; from the lots of car dealers with neon paint to hand-to-hand-to-pocket tips for bellhops and restaurant servers; from fleeting ones and zeroes soaring at light speed across the internet to long-term contracts for land use or film production.

One number couldn't even begin to describe the magnitude and dynamic nature of something like the "price level." It would be like driving out West for a camping trip and going to the remotest location at night to view the stars and a meteor shower and then the next month, when you return to civilization and cell service you text your parents what the view was like and type, "Cool."

Price index information is delayed, incomplete, and by its very nature incapable of describing the astronomical picture of market prices. And we haven't even mentioned the well-cited issues with surveys, government data, and the more specific issues with the particular measurements.

Inflation Is About More Than the Price Level

A third issue with viewing inflation only as a rise in the price level is that it stops short of explaining the full consequences of monetary inflation. Many people correctly understand the relationship between the price level and the money supply — more money means higher prices — and they also understand that this relationship is bad for the average Joe.

Now, Dr. Salerno is not average by any measure, but we can say that if he is one of the later receivers of new money, he has to pay higher prices before his own salary increases due to inflation, however you define it.

In this way, inflation is not harmless — it represents a wealth transfer to the first users of the new money from the later users of new money as it ripples through the economy.

Even though most people know and understand this consequence of increasing the money supply, it stops short of explaining the full consequences of monetary inflation, which will be discussed in just a moment.

But to summarize, viewing inflation as a rise in the price level has at least three main problems:

1. It is ambiguous because almost anything can change prices;

2. It is impractical because it can't be appropriately measured;

3. And it is incomplete because it doesn't tell the whole story of increases in the money supply.

Inflation is more appropriately viewed as an increase in the money supply, and this conception of inflation does not suffer the same problems as the other. Monetary inflation has a simple, well-defined cause, unlike price inflation. Monetary inflation is measureable because money is its own unit of account and can be counted up, unlike price inflation, which is not directly measureable. Monetary inflation is also the starting point for the business cycle story, instead of a stopping point for many, like price inflation.

Before we can discuss the ups and downs of the business cycle, we have to gain an understanding of two connected concepts: the interest rate and production.

The interest rate is a price, like any other price, but for present money. It seems weird that you can buy money, but if you just reverse your perspective of any regular transaction, "buying money" becomes an obvious and ubiquitous part of our day-to-day lives.

When you buy an Apple Watch (or two) you exchange money for the device. From Apple's perspective though, they are not only selling the watch, but buying your money. The price of your $600 is one Apple Watch.

The Interest Rate Is a Price of Present Money, In Terms of Future Money

When you take out a loan, you are buying present money in exchange for the promise of a future payment. The relative difference between these two sums is the interest rate. And, just like any other good, the lower the price, the more people will want to buy. At lower interest rates, more people are willing to borrow.

In modern times, we've outsourced a lot of the lending to banks, which act as financial intermediaries. Banks use our savings to lend to prospective borrowers, and so the supply of loanable present money depends on how much people save — said another way, it depends on how much people consume, since saving is the opposite of consumption.

The indirectness of borrowing and lending through banks does not complicate things too much; in fact it makes it easier for us to conceive of the supply of loans simply as savings.

Entrepreneurs are some of the primary borrowers of present money. Entrepreneurs buy factors of production like land, labor, and capital to produce goods and services. They will only engage in production, though, if they expect to profit, that is, if their revenues exceed their costs.

Entrepreneurs Must Consider the Cost of Debt Service

If they borrow money to pay for the factors of production, then the profit would also have to exceed the interest they promise to pay for the borrowed funds.

For this reason, the interest rate is a vital piece of information for entrepreneurs. If interest rates are high, then only high-revenue lines of production will be undertaken. If interest rates are low, then more lines of production become profitable.

In an unhampered market, interest rates are determined by supply and demand. If people become more willing to part with their present money, or save, then the supply of loanable funds will increase relative to demand, and the interest rate will fall. At the lower interest rate, more lines of production will become profitable because now entrepreneurs can borrow more cheaply to purchase factors of production. Since this scenario started with people becoming more willing to save, it's also clear that the entrepreneurs will be able to purchase the real resources required for production. Consumers have shown that they are willing to consume less, so now, more resources can be used by producers for production.

Let's walk through a specific example of how this works:

Suppose Tim Cook has an idea for how to produce one million Apple Watches and expects revenues from his sales to exceed his costs by 10 percent. He doesn't have the money to pay for the machines and the laborers and the factories required to produce the watches, so he needs to borrow. The current interest rate is 15 percent, unfortunately for Tim Cook, so he just holds on to his idea for the time being.

However, a couple months later, due to the increased willingness for people to save and invest, the interest rate falls a whopping 10 percent, down to just 5 percent. Tim Cook reevaluates his plan and his expectations of profitability and decides to go for it. He borrows the money necessary to pay for laborers, machines, and factories and starts producing Apple Watches.

He sells his product and gets revenue that exceeds his cost by 12 percent — a little more than he was expecting! He pays back his creditors the amount he promised, 5 percent, which left him with 7 percent all to himself for taking the risks and producing something consumers like.

The lower interest rate in this example encouraged the entrepreneur to produce and also signaled to the entrepreneur that resources have been freed up in the economy for use in production. Now let's see what happens when entrepreneurs get a false signal from credit markets via monetary inflation.

When Central Banks Get Involved

When a central bank decides to increase the money supply, the new money enters the economy through the same markets that people borrow and lend.

The new money increases the supply of present money available for lending, which, as we all know, will decrease the price, or the interest rate in this case.

To be clear, this time, the lower interest rate does not reflect people's willingness to save or invest, but only reflects the central bankers' intervention. This artificially low interest rate sends all of the same signals to entrepreneurs and lenders that a normal interest rate does, but is not based on people's real preferences.

When the central bank increases the money supply and interest rates fall, it induces more borrowing and less saving. Entrepreneurs are more than happy to take out the loans at the lower interest rate, but everybody else is less willing to save at the lower interest rate. The newly printed money makes up the difference.

Less saving means more consumption, and since the interest rate is so low, consumers may even borrow to finance even more consumption. Entrepreneurs take their funds and purchase factors of production, and at the new, lower interest rate, the lines of production they undertake are the ones that weren't as profitable before. Everybody is happy as they consume, invest, earn higher wages, start new projects, and enjoy the ride to the top.

The Down Side

This high cannot last forever, though. Even though spending is climbing on all fronts, no new resources have been created, just new green slips of paper. The economy has not allocated real resources away from consumption and toward production, it has just stretched the existing resources thin. The signals entrepreneurs rely on were falsified and based on the whims of a few powerful people, not the collective, voluntary interactions of individuals everywhere.

The boom peaks and falls into a bust when some combination of these events unfolds:

1. When the increasingly scarce factors of production become too expensive;

2. When the monetary spigot gets turned off and so consumption and investment run dry;

3. And when people start to realize the damage that has been done.

The bust is characterized by under- and unemployment, falling prices, and a readjustment of capital throughout the economy. The bust is painful, but necessary and healthy.

Capital and laborers have been misallocated, funds malinvested, and lines of production that appeared to be profitable are revealed to be unprofitable in hindsight. The correction happens during the bust. In fact, the bust is the correction. Resources need to go where they are most highly valued, and the only system capable of such a daunting task is the unhampered market economy.

In the past and up to today, the necessary correction hasn't been allowed to run its course before central banks reinflate and restart the cycle. So, it's unfortunate that we have to call it the boom-bust "cycle," instead of the boom-bust "event." If it were a one-time thing, we might forgive the ones responsible and say, "Ok, that was an interesting experiment. We didn't really think it was going to work, but now everybody knows." Like the George Clooney/Arnold Schwarzenegger Batman movie.

But as the term "business cycle" suggests, the artificial booms and the painful busts continue because some people, especially the government, stand to benefit at the expense of others and because of a general lack of understanding of even the fundamental mechanisms at work.

We can avoid the mess. People are getting into and developing currencies that are not tied to our fractional reserve and central banking system. Newer technologies are being adopted for loans to be processed at rates less affected by central bank manipulation.

Many people are realizing the disastrous record of central banking and expansionary monetary policy. The same people are learning the way to real economic growth via real savings and economically sustainable uses of our resources.

Maybe one day we'll look back at the wrecking ball swings of our current economy the same way we look at Batman & Robin starring George Clooney and Arnold Schwarzenegger: laughing, but cringing and shaking our heads.